2.2 Credit growth and quality a manageable risk

This sub-section discusses the medium-term risks arising from the rapid expansion of credit in China in 2009 and 2010 and looks more specifically at central and local government debt. It recognises that the rate of credit growth may be explained in terms of China's stage of development and institutional factors, but it may still pose a risk to the financial sector and the government. Total government debt is higher than official figures suggest, but bad debts could be absorbed by central government without raising debt ratios to unsustainable levels.

2.2.1  Rapid economy-wide credit growth

Figure 2 – China's credit growth

Source: Haver Analytics

China experienced annual credit growth of 30% in 2009 and 20% in 2010 (Figure 2); it is estimated that this increased outstanding credit to around 180% of GDP from less than 150% prior to the global financial crisis (GFC).[9] This credit expansion was part of the government's stimulus package launched in November 2008 in response to the GFC and which funded an investment boom.[10] Much of the credit was extended by banks to local government investment corporations for infrastructure projects as local governments are not permitted to borrow.

The high credit growth in 2009 and 2010 followed a period in which credit grew at about the same rate as GDP; annual credit growth averaged 15.6% between 2004 and 2008 while nominal GDP growth averaged 18.0% per annum in that period. There is a concern that the rapid growth in 2009 and 2010 led to an increase in bad debts, threatening the stability of the banking system and leading to a slowdown in investment and GDP growth. Although this risk has not eventuated yet, it could be exposed by an economic slowdown or weakness in the housing market. By mid-2012, credit growth had declined to the target of about half its rate of growth in 2009, but Fitch estimate that outstanding credit stood at 200% of GDP in 2012, partly through expansion of the shadow banking sector.[11]

The level of credit outstanding in China is high relative to other emerging economies (eg, 51% for India, 59% for Brazil) and more than the US (108%). This difference is usually explained as a result of the underdevelopment of capital markets for corporate investment in China and is related to the dominance of banks in the financial system, combined with high household and corporate saving rates. More than half of private wealth is held in bank deposits. While the level of credit relative to GDP can be partly explained by the stage of development of the financial system and the economy, the rapid growth in credit in 2009 and 2010 and subsequently poses a risk to credit quality and financial stability.

The issue of credit quality is compounded by an increase in informal securitisation of debt in the Chinese financial system. Lending growth may not have slowed recently as much as official figures suggest, as there has been an increase in credit being shifted off bank balance sheets through informal securitisation. Fitch points out that most of these transactions are not disclosed, resulting in an understatement of credit growth and exposure.[12] As a result, Chinese banks' loan loss reserves and capital are much more exposed to potential credit losses than official data suggest.

Other issues associated with the rise in informal securitisation are that it does not fall under the control of the authorities, but any extension of regulation could be negative for growth in the short term as there is clearly a demand for both the credit and the investment products. If the credit were brought back onto bank balance sheets, the banks would need more capital. There have been moves to bring some of this off-balance sheet credit under regulatory control, but it is not known how successful these efforts have been.

The International Monetary Fund (IMF) considers that, given the large expansion in credit recently, China's banking system would be exposed if a number of shocks all occurred at the same time (eg, lower growth, a sharp fall in real estate prices and higher interest rates). Smaller banks with insufficient capital to meet regulatory requirements would be particularly at risk. The IMF considers that the three main areas of risk to credit quality are loans to local government financing vehicles, off-balance sheet lending and lending to the property sector.[13]

2.2.2  High central and local government debt

A closely related issue is the level of outstanding government debt in China. The official figure for general government debt (ie, central plus local government) peaked at the end of 2010 at RMB13.5 trillion (33.5% of GDP);[14] most commentators take this figure as including only central government debt.[15] Estimates for total government debt (ie, including local government debt) at the end of 2010 are much higher than this; in June 2011, two sets of figures were released ranging from RMB10.7 trillion (26.9% of GDP) from China's National Audit Office (NAO) to RMB14.4 trillion (36.2% of GDP) from the People's Bank of China (PBoC); the difference between these figures may reflect different definitions of local government debt. An earlier figure from the China Banking Regulatory Commission put local government debt at RMB9.1 trillion in late 2010 (22.9% of GDP). Moody's have estimated that the local government debt figure is approximately one third higher than the NAO figure (an additional RMB3.5 trillion), taking the figure closer to the PBoC figure of RMB14.4 trillion.[16]

The NAO figure was accompanied by a breakdown of the debt: 24% was set to mature in 2011 and 70% over the next five years; 2% of the debt was in arrears and 5% had been rolled over using bank loans; more than 90% of the debt was created in 2009 and 2010 as part of the infrastructure stimulus. Nearly 80% of the total was funded by bank loans and approximately half of it (RMB5 trillion) was extended to Urban Development Investment Vehicles and was used mainly to finance social infrastructure projects.

If the official figure refers only to central government debt and if we adopt the NAO figure for local government debt, total gross government debt was around 60% of GDP at the end of 2010. McKissack and Xu (2011) estimate total government debt to be in the range of 60-70% of GDP. Some estimates of total public debt, including non-performing loans of the banks and central bank bills, put the figure at around 80% of GDP.[17]

It was also reported in June 2011 that authorities plan to shift RMB2-3 trillion off local governments' balance sheets through write-downs by the banks concerned, repayment of loans directly by central government or the creation of asset management companies to handle bad debts. The last approach was used in the late 1990s when the government set up such structures to handle the bad debts from a previous banking crisis. These organisations are reported to have had low debt recovery rates.[18]

Some reports suggest that one-quarter to one-third of local government loans may fail to generate a financial return.[19] If local government debt amounts to 27% of GDP (the NAO figure and the middle one of the three estimates), the bad debts of the local government sector are likely to amount to around 7-9% of GDP. While not insubstantial, such a cost could be taken on by central government, bearing in mind that not all of the debt would have to be absorbed by the government. Some of it would be recoverable, leaving possibly 5% of GDP to be taken on by the central government. In the context of gross debt of around 23% of GDP at the end of 2012, such an amount would be manageable for the central government, but anything significantly above that level would have a more serious impact.

The mitigating factors in relation to China's public debt are that the debt is held domestically, resulting in less exposure to international financial markets, and the debt has mostly been applied to fund infrastructure projects which should yield some return in the future (even if a social return), whereas some other governments' debt has been applied to social programmes or defence, which will not produce a similar economic benefit. While excessive credit growth does pose a risk to the banking system in China, the government would be able to absorb an increase in bad debts of around 5% of GDP arising mainly from the local government sector as part of its 2009-2010 stimulus package. However, the impact on the banking sector, and ultimately on the government's debt level, would depend on the proportion of non-performing loans. As elsewhere, a sharp slowdown in growth would exacerbate any debt problems.